Economic Logic, Too

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I discuss recent research in Economics and various events from an economic perspective, as the name of the blog indicates. I plan on adding posts approximately every workday, with some exceptions, for example when I travel.

Friday, January 31, 2014

Economies may need to be stimulated sometimes, through tax reductions or public expenditures. The problem is that this costs. Opposition to such stimulus programs is typically grounded on the unavoidable debt run-up, which implies that at some point in the future taxes will need to be raised at a level that is higher than before the stimulus. Would there be a way to pacify this opposition?

According to Laurence Seidman there is. It involves the Federal Reserve, or the corresponding central bank, making a loan to the government treasury for the amount engaged in the stimulus, and then the Fed conveniently forgiving this debt. That is a different way of putting what Seidman proposes: the Fed makes simply a transfer to the Treasury that satisfies the dual mandate of the Fed, full employment and stable prices. Despite what Seidman claims, this is monetizing the debt. Even if no debt is explicitly created, the government is still financing its stimulus by (virtually) printing money, and with the same effect on inflation which guarantees that the dual mandate will not be satisfied for stable prices, and one can have doubts about full employment, too. Seidman argues that there would be no inflation if aggregate demand gets back to the "normal" level with the stimulus. But you still have increased the money supply for the same quantity of goods. The price level needs to increase accordingly. The only way to avoid the inflation is if the Treasury returns the transfer to the Fed. The transfer is thus again a debt.

I find it really strange that a chaired professor at the University of Delaware would write this. The only way I can rationalize his writing is that he confuses real and nominal quantities. He also seems to reason in partial equilibrium, not thinking that prices adjust to such large changes in macroeconomic aggregates, especially in the medium run. We are used to seeing this from crackpots with little economics education, but not with apparently well-educated economists.

I think this kind of errors happen when you do not formalize your thoughts with a model. People may complain of the mathematization of economics, but it has a huge advantage in making sure your logic holds. And this is a perfect example of what goes wrong when you do not use a model.

I take issue with your statement "But you have increased the money supply for the same quantity of goods." In a situation where the economy is producing below its capacity, the extra money would lead to greater demand which would increase the quantity of goods produced. So it would be an increase in the money supply with an increase in the quantity of goods as well.

Your point holds in an economy which is producing at capacity, but that isn't what Seidman is considering.

A simple debt-free stimulus is to find those that have great assets and are not spending and tax them then spend the money that comes in. Or, take the money that comes in an give a tax break to those who are likely to spend most of it. These include mostly lower wage earners. Voila! instant stimulus.